Oil: An Intermediate High in US$ Terms and a Major High in Gold Terms

The oil price surged at the end of August last year in the wake of Hurricane
Katrina, but it had been trending higher for some time prior to that event;
Katrina's destruction of oil production facilities just prompted the final
flurry of buying that created 'the top' and set the stage for an intermediate-term
correction. Interestingly, the price action surrounding the recent top looks
similar to the price action surrounding the 2005 Katrina-related top. In the
most recent case the Israel-Hezbollah conflict provided the news backdrop that
prompted the flurry of buying that MIGHT have resulted in an intermediate-term
price top.

We have been and continue to be long-term bulls on oil. Furthermore, we strongly
believe that the world desperately NEEDS a much higher oil price in order to
make the massive reserves of non-conventional oil economic. We are, however,
guilty of not being bullish enough on oil on a short- or intermediate-term
basis during 2004-2005. Perhaps we are once again going to be guilty of not
being bullish enough on oil in the short- or intermediate-term, but with economic
growth looking set to decline over the coming quarters a considerably higher
oil price is going to require a major supply disruption. There's always a significant
risk of a major supply disruption in the oil market because so much of the
world's oil comes from politically unstable countries, and for this reason
alone we would never want to be 'short' oil. But even given the current situation
in Lebanon, we don't think a Middle-East-related supply disruption is a high
probability outcome as far as the next few months are concerned. There is,
of course, the possibility that a hurricane will shut-down a lot of oil production
in the Gulf of Mexico this year as it did last year, but this, also, is not
a high probability outcome.

As far as the next few years are concerned, our expectation is that the oil
price will reach the $100/barrel price target that's been bandied about over
the past 15 months. We also expect that oil will UNDER-perform some other commodities,
most notably natural gas and gold. The reason is that the oil price is extremely
high relative to the prices of these other commodities. We discussed oil relative
to natural gas last week, so this week we are going to take a look at oil relative
to gold and have included, below, a long-term chart of the gold/oil ratio.

Relative to oil, gold has been in a downward trend for about 10 years and
hit an all-time low at the end of August-2005 in the wake of Hurricane Katrina.
In our opinion, the flurry of oil buying in the days following last year's
hurricane combined with the weakness in the US$ gold price at the time paved
the way for a major trend change. A major trend change would be confirmed by
the gold/oil ratio moving above 10.

Not coincidentally, the last big rally in the gold/oil ratio occurred between
the final quarter of 2000 and the final quarter of 2001 -- during a period
when the economic growth rate was slowing and the yield-spread was widening.
Slowing economic growth and a widening of the US yield-spread are what we expect
to see over the coming 12 months.

With the gold price being extremely low relative to the oil price and with
economic conditions likely to become increasingly supportive of gold relative
to oil over the coming quarters we think a substantial rally in the gold/oil
ratio is a good bet.

Oil versus Oil Stocks

There is a tendency for important tops in the major gold stocks to precede
important tops in the gold price. The relationship between oil and oil stocks
is, however, quite different in that tops in the major oil shares tend to occur
AFTER tops in the oil price. For example and as illustrated by the following
charts, the AMEX Oil Index (XOI) continued to trend higher for 7 months after
the Q4-2000 peak in the oil price and for 9 months after the Q1-1997 peak in
the oil price. Therefore, even if an intermediate-term correction has begun
in the oil market it's quite possible that oil shares will continue to trend
upward for several months.

The factor that determines the timing of the next intermediate-term peak in
the major oil shares is likely to be the performance of the broad stock market.
If the broad stock market continues to trend lower over the coming months then
it's unlikely that oil shares will 'buck the trend', but if the broad stock
market can rebound over the next few months then the XOI will probably make
new highs even if the oil price has already peaked.